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1 1 XX - Income Taxes (IAS 12, ASPE Section 3465): While this section is not usually heavily tested from a case-writing standpoint, it is a staple on the Core 1 Examination. Most Core 1 examinations contain 2-3 questions on this section. Thus, if you are writing (challenging) the Core 1 examination, we urge you to spend some time on this section. In particular, many candidates seem to struggle with Deferred (Future) Income Tax Assets and Liabilities. This section was written with this in mind. This section contains two parts: Part A: Temporary & Permanent Differences and; Part B: Tax Loss Carry forwards Part A: Temporary & Permanent Differences: The purpose of this section is to explain how to reconcile accounting income to taxable income, to calculate taxable income and to prepare all tax-related journal entries. This part will focus on the computation of taxable income as well as deferred tax assets and liabilities arising from temporary differences. Please note that we will be releasing a comprehensive Taxation manual later on during Permanent Differences are those which affect either taxable income OR accounting income, but not both. They are called permanent differences because they never reverse out. Consequently, they do not give rise to deferred income tax assets or liabilities. Timing Differences: Also known as reversible differences, these arise due to items that affect both accounting and taxable income but at different rates. The following is a list of common permanent and temporary differences:

2 - Golf - Dividends - 50% - 50% - Fines - Life - Warranty - Pension - Revenue - Rent 2 Common Temporary & Permanent Differences: Permanent Differences: Dues from Taxable Canadian Corporations of meals and entertainment expenses of Capital Gains and penalties Insurance premiums on death of an executive. Temporary (Reversible) Differences: - CCA/Depreciation expenditures/expense Contributions/Expense Collected/Revenue (income statement) Expenditures/Expense Note that there are others, but these are the most common ones. Taxes Payable: Is equal to the taxable income * current (enacted) tax rate. The related entry will be as follows: Income Tax Expense Current Income Tax Payable xx xx Income taxes payable would be classified as a current liability on the balance sheet. Deferred Income Tax Assets & Liabilities: These arise from the cumulative timing/reversible differences. It is Students frequently encounter difficulties in calculating deferred tax assets and liabilities. They usually make one of 3 mistakes: They incorrectly identify a cumulative difference as a deferred tax asset instead of a deferred tax liability or vice versa. They use the wrong tax rate when computing the tax asset balances. Of course this is a non-issue when only one tax rate is given, but often you will be given multiple tax rates. They focus solely on deferred tax expense, forgetting that DTAs and DTLs, like all balance sheet accounts are cumulative in nature.

3 3 Calculating DTA/DTL Balances & Related DIT Expense amounts (Painlessly): It is important to note that as a general rule, Canada Revenue Agency (CRA) allows an item to be deducted or is taxed when the item is paid for or collected. In other words, CRA essentially works on the cash basis while accounting income is computed using the accrual basis. A notable difference to this rule is the treatment of Book Value/UCC vs. depreciation expense/cca. Some examples include: Warranty Expenditures vs. Warranty expense: The expenditure is deducted ON the tax return when paid for, while the expense is deducted on the books as accrued. The cumulative difference between these will give rise to DTA or a DTL. Depreciation vs CCA: If CCA> Depreciation (i.e. Book Value > UCC) taken to dates, this will give rise to a DTL. The reverse will give rise to a DTA. Deferred Tax Asset or Liability? When an item has resulted in higher taxes paid (and therefore taxes payable), then that will result in a DTA. Of course, the opposite will result in a DTL For instance, if interest expense paid to date was $100,000 and interest expense to date was $120,000, this would result in a DTA, since less tax was deducted on the tax return than on its books. In practice, this would occur when bonds are issued at a discount. In this case, the cumulative amortization of the discount would be $20,000. If the company s tax rate going forward was known and expected to be 30%, this would give rise to a DTA of $6,000 (($120,000-$100,000) *30%). If this had been the only difference to date, this DTA amount could also be thought of as a prepaid The company paid $6,000 more in taxes to date than it recorded taxes on its books. Conversely, had $120,000 of rent been collected and $100,000 of rent revenue recognized, the company would have a DTL of $6,000. There are several quick hacks to help you understand whether or not you have a DTA or DTL. You only need to know one. These include: - Thinking of these as a prepaid (DTA) or an accrued liability (DTL).

4 4 - Another quick hack would be to simply remember that the DTA or DTL goes on the other side of the balance sheet item. For instance, Prepaid insurance, on the books would give rise to a DTL, since the company has expensed more on its tax return than on its books. Conversely, interest payable would be the result in higher interest accrued than paid (deducted) for tax purposes, and therefore a DTA, since you have a greater future tax deduction available in the future, once the undeducted amounts are deducted. - Similar to the last point above, higher asset values on the books than for tax returns can be thought of resulting in higher future cash flows resulting in higher taxes payable in the future, and therefore a DTL. Should you find any of the above points confusing, do not worry, you need only remember one! Fixed Assets: When fixed assets are purchases CCA may be deducted. As per the explanations above, greater CCA deducted to date than depreciation expense to date will result in a DTL. Book Value vs. UCC: Book values in excess of UCC are the result of less depreciation expense taken for book purposes than CCA. The reverse is also true. Finance Leases & Asset Retirement Obligations(AROs): Finance Leases and AROs will also result in DTAs or DTLs when amounts deducted on the books differ from those paid. However, unlike the other financial statement elements mentioned above, there is usually an asset and related liability on the books. For instance, a company may have assets of 100 under finance leases and a related lease obligation of 110. In this case, the easiest thing to do is net these to out and think of them as a single asset or liability. In this case, we can think of this arrangement as a liability of 10 on the books, thereby resulting in a DTA ( )*tax rate. Note that DTAs or said to give rise to deductible amounts while DTLs are said to give rise to taxable amounts. Which tax rate do I use to value my ending DTA/DTL? You will use the rate which is substantially enacted (known). If the rate that is substantially enacted when the reversal of the difference is expected to take place is known, that is the rate that is used to value the DTA/DTL. Otherwise the current rate is used. Sometimes, only a single tax rate is given in a question, rendering this point moot. However, we feel you are more likely to be given multiple tax rates in a question. This section has been written accordingly.

5 5 What about Deferred Income Tax Expense? This one is simple! The DIT expense is simply the difference between the opening and ending DTA/DTL amounts. Please note that cumulative difference may result ina DTA in one year and a DTL the next or vice versa. This is not always the case, however. Steps for computing DIT Expense: Step 1: Compute opening DTA/ DTL amount using steps described above. Step 2: Repeat Step 1 for the ending balance. Step 3: Take the difference between Steps 1 and 2. **TIP: When you are given different tax rates, NEVER focus on the DIT expense (current year itself). It is much safer (although longer to do) to follow the steps above. You can ONLY hone in on the the current year difference if your are given a single tax rate. However, on the Core 1 exam, chances are you will be given two tax rates. Note that the above steps will ALWAYS work, regardless of how many tax rates you are given. ** Let us now look at two examples: Example 1: Suppose that a company s sole temporary difference gave rise to a DTA of 100 at the end of Year 1 and a DTL of 15 at the end of Year2. This would give rise to the DIT expense amount of 250 (to go from an asset of 100 to a liability of 150. Example 2: A company has a single rental property. Suppose that at the end of Year 1, the building had a Book Value of $800,000 and a UCC amount of $760,000. During Year 2, the company took CCA of 20,000 and depreciation of $80,000. The rate for Years 1 and 2 was 20%. The tax rate for Year 3 and beyond was expected to be 25%. This rate was known at the end of Year 2. Step 1: At the end Year 1, we would have a DTL amount of $8,000. ( ) *20%. Step 2: At the end Year 2, we would have a DTA amount of $5,000. * * ((800-80) -(760-20)) *25%.

6 6 Step 3: To go from a DTL of $8,000 to a DTA of $5,000, we would record a DIT Benefit on the income statement. Putting it all together: The following steps are required to answer any comprehensive questions on this topic (assuming no tax loss carry-back or carry forwards). Step 1: Compute Taxable Income. Step 2: Record Income Taxes Payable/Current Income Tax expense: Step 3: Value DTAs/DTL balances and calculated DIT expense/benefit using the steps described above. Total income tax expense on the income statement is the sum of the current and deferred income tax expense amounts. Comprehensive Example 1: Jones Inc. is a publicly traded company. During Year 5, the company reported a pre-tax accounting income figure of $560,000. Included in this figure was $50,000 of meals and entertainment expenses, $100,000 of depreciation expense, and $20,000 of interest expense. The company paid $18,000 in interest expense and took $120,000 of CCA. Jones Inc. was subject to a tax rate of 32% during Year 5. For Years 6 and beyond, the tax rate will be 35%. This rate was enacted during Year 5. Jones uses a single Deferred Tax account to account for its temporary differences. At the start of Year 5, Jones Inc. reported a Deferred Tax Asset (DTA) of $4,800. Required: Apply the steps shown earlier to compute taxable income and to prepare all of Jones income taxrelated journal entries for Year 5.

7 7 Step 1: Taxable Income, Year 5: Pretax Accounting Income: $560,000 Add: Permanent Difference: Meals & Entertainment (50%) $25,000 Add/Deduct: Temporary Differences: Deduct: Excess of CCA over depreciation ($20,000) Add: Excess of interest expense over interest paid $2,000 Taxable Income $567,000 Step 2: Current Income Tax Entry: Calculation of income taxes payable: $567,000*32%=$181,440. Income Tax Expense Current $181,440 Income Taxes Payable $181,440 Step 3: Calculation of Deferred Tax Amounts: Step 1: Opening Deferred Tax Balance: Note that in this example, only the opening DTA amount of $4,800 is given. It may be helpful to unravel this amount by dividing it by its tax rate: $4,800/0.32=$15,000 Deductible Amount. From here, we can use this amount as a springboard to calculate our ending DTA/DTL amount. This dones as follows: Opening Difference: $15,000 Deductible Deduct: Excess of CCA over depreciation ($20,000) Taxable Add: Excess of interest expense over interest paid $2,000 Deductible: Ending Difference: $3,000 Taxable

8 8 Therefore, we would have an ending DTL amount of $3,000*0.35=$1,050. Step 2: Closing Deferred Tax Balance (Given): $4,800 DTA. Step 3: To go from a $4,800 DTA opening balance (Step 2) to a $1,050 DTL (Step 1), the following entry would be made: Deferred Income Tax Expense $5,850. Deferred Tax Asset/Liability* $5,850 *Technically, DTA accounts should first be closed, and then the DTL of $1,050 recorded. However, we thought it would be more expedient to skip this step. **Note that the total income tax expense in this problem is $181,440 (Step 2) + $5,850 (Step 3) =$187,290. ** Effective Tax Rate: The effective tax rate must be disclosed under IFRS. It is computed as the total income tax expense (current and deferred) divided by taxable income. In this example, the effective tax rate is: Current Income Tax Expense: $181,440 Deferred Income Tax Expense $ 5,850 Total Income Tax Expense: $187,290. Effective Tax Rate: $187,290 / $567,000 =33.03% (rounded). Some Complications: 1. Deferred Tax Amounts on Land vs. Depreciable Assets: Under both situations, you still need to figure out the book basis and tax basis and apply the correct rate. HOWEVER, land is different than depreciable assets, in that any profits on land or only generated through capital gains when sold (unlike depreciable assets, whose profits are realized through operating income). All this means is do what you do for depreciable assets and then apply 50% rule. 2. Tax Loss carryforwards vs. Capital Loss Carryforwards:

9 - major - current - any - amount - amount - amount - write - amount 9 Ditto above. Both trigger DTAs. However, we take 50% for Capital Loss carry forwards. Classification: Current income tax is a current item, while deferred income tax is always a long-term item under IFRS. The classification of deferred tax balances is not affected by the nature of the asset or liability that gave rise to the deferred tax and regardless of when the temporary difference will reverse. Netting: The deferred income taxes relating to all assets and liabilities are lumped together and netted as a single amount for the same taxable company and the same taxing government. Note that the decision to net (or not to net) can have consequences on certain ratios, such as the debt-to- equity ratio. Goodwill: If Goodwill ha a tax basis, it can give rise to DTAs or DTLs. Otherwise, its tax basis is nil. Disclosures: IAS requires the following disclosures: components of tax expense (tax income) [IAS 12.79] Examples include: tax expense (income) adjustments of taxes of prior periods of deferred tax expense (income) relating to the origination and reversal of temporary differences of deferred tax expense (income) relating to changes in tax rates or the imposition of new taxes of the benefit arising from a previously unrecognized tax loss, tax credit or temporary difference of a prior period down, or reversal of a previous write down, of a deferred tax asset of tax expense (income) relating to changes in accounting policies and corrections of errors.

10 - aggregate - tax - explanation - changes - amounts - temporary - for - tax - tax - information - recognition - details - tax 10 IAS requires the following disclosures: current and deferred tax relating to items recognized directly in equity relating to each component of other comprehensive income of the relationship between tax expense (income) and the tax that would be expected by applying the current tax rate to accounting profit or loss (this can be presented as a reconciliation of amounts of tax or a reconciliation of the rate of tax) in tax rates and other details of deductible temporary differences, unused tax losses, and unused tax credits differences associated with investments in subsidiaries, branches and associates, and interests in joint arrangements each type of temporary difference and unused tax loss and credit, the amount of deferred tax assets or liabilities recognized in the statement of financial position and the amount of deferred tax income or expense recognized in profit or loss relating to discontinued operations consequences of dividends declared after the end of the reporting period about the impacts of business combinations on an acquirer's deferred tax assets of deferred tax assets of an acquiree after the acquisition date. Other required disclosures: of deferred tax assets [IAS 12.82] consequences of future dividend payments. [IAS 12.82A] In addition to the disclosures required by IAS 12, some disclosures relating to income taxes are required by IAS 1 Presentation of Financial Statements, as follows: - Disclosure on the face of the statement of financial position about current tax assets, current tax liabilities, deferred tax assets, and deferred tax liabilities [IAS 1.54(n) and (o)] - Disclosure of tax expense (tax income) in the profit or loss section of the statement of profit or loss and other comprehensive income (or separate statement if presented). [IAS 1.82(d)]

11 11 ASPE: Private companies may use either the taxes payable method (forbidden by IFRS) of accounting for income taxes or the comprehensive allocation method (used under IFRS). This method is called the Future Income Taxes under ASPE. Under the taxes payable method, income tax expense is simply the amount of current income tax paid (or payable) to the government, with no inter-period allocation and no deferred income tax amounts. A company must use either method and cannot combine methods. Note that many companies following ASPE opt to use the taxes payable method due to its simplicity and higher correlation to cash flow reporting. Terminology: The CPA Handbook uses the term future income tax instead of deferred income tax but the two terms are used interchangeably. Classification: The Canadian standard requires companies to classify deferred income tax liabilities as either current or long-term, in contrast to IFRS which requires long-term classification. Disclosure: There are fewer required disclosures under ASPE. In the accounting policies note, the company should disclose the fact that it is using the taxes payable method. There is also the recommendation that the company disclose significant tax policies. The company should also reconcile its income tax expense to the average statutory income tax rate. Part B: Tax Loss Carrybacks/Carry-Forwards: Tax losses can be carried back 3 years to get back any amounts already paid to CRA. Tax losses can be carried forward to the extent that the company believes that it will realize enough taxable income against which any remaining tax losses can be used. Tax Loss Carryforwards will result in Deferred Tax Assets (DTAs) in addition to those already recorded due to any temporary differences. These DTA do not affect the entries made to account for temporary differences.

12 - A - Enough - The - The - A - There 12 As mentioned above, the company must meet the more likely than not criterion described above in order to justify recognition of a DTA Tax Loss Carryforward. IAS 12 provides certain guidelines to help determine whether or not this criterion has been met: Evidence of Probability: Guidelines in IAS 12 state that favourable evidence to support recognition include: strong earnings history, interrupted only by an unusual event that caused the loss accumulated temporary differences to absorb the unrealized loss as the temporary differences reverse; or existence of tax planning opportunities that will create taxable profit in the carry forward period. Probability criterion will not be met if: company has a history of tax losses expiring without being used; change in the company s economic prospects indicates that losses may continue for the next few years; and are pending circumstances that, if not resolved in the company s favour, will impair the company s ability to operate profitably. Nature of evidence supporting recognition of any benefit of a tax loss carry forward must be disclosed in the notes. Tax Planning Adjusting Temporary Differences: A company will have a higher amount of undepreciated capital cost (and CCA) in future years if it claims less CCA in the current year. Companies make these decisions based on advice from their tax-planning advisors. Reducing CCA: One way of increasing the likelihood that a company will fully utilize a carry forward is to eliminate CCA in the carry forward years. A further strategy is to amend prior years returns to reduce or eliminate CCA. Reassessment in Years Subsequent to the Loss Year: The tax loss will carry forward asset is subject to review at each reporting date. If the probability of realization drops to 50% or less, it should be reduced. The asset may be recognized in the year of the loss or in any subsequent year if management judges that the probability of realization is greater than 50%. Previous years are not restated. Impact of Recognition Assumption on Net Income:

13 13 Financial statement users should be wary of income tax recoveries that are recognized but not realized as management may be tempted to manage reported earnings a potential ethical issue. Write-off of Expired Carry forward Benefits: When a company reaches the end of the carry forward period for any tax loss, any remaining DIT asset balance must be written off. When an allowance account is used, the expired portion of both the DIT asset and the valuation account must be written off. Use of a Valuation Allowance Account: Many companies prefer the valuation allowance method because it keeps track of the full tax loss carry forward benefits and is consistent with the approach of other financial statement elements (e.g. accounts receivable). Use of a Valuation Allowance account is optional. Comprehensive Example 2: Jones Inc. is a publicly traded company. During Year 5, the company reported a pre-tax accounting loss figure of $480,000. During Years through 4, reported taxable income amounts totaling $285,000 and paid income taxes amounting to $85,400. Jones wishes to carry back its Year 5 tax loss to get back as large a tax refund as possible. The company expects to be able to carry forward any remaining tax losses. Included in this figure was $50,000 of meals and entertainment expenses, $100,000 of depreciation expense, and $20,000 of interest expense. The company paid $18,000 in interest expense and took $120,000 of CCA. Jones Inc. was subject to a tax rate of 32% during Year 5. For Years 6 and beyond, the tax rate will be 35%. This rate was enacted during Year 5. Jones uses a single Deferred Tax account to account for its temporary differences. At the start of Year 5, Jones Inc. reported a Deferred Tax Asset (DTA) of $4,400. Required: Apply the steps shown earlier to compute taxable income and to prepare all of Jones income taxrelated journal entries for Year 5.

14 14 Step 1: Taxable Income, Year 5: Pretax Accounting Loss: ($480,000) Add: Permanent Difference: Meals & Entertainment (50%) $25,000 Add/Deduct: Temporary Differences: Deduct: Excess of CCA over depreciation ($20,000) Add: Excess of interest expense over interest paid $2,000 Taxable Loss ($473,000) Step 2 - Current Income Tax Entry: No taxes payable, however, Jones can get back all the taxes it had paid during the prior three years by carrying back $285,000 of its $480,000 loss and carrying forward $195,000 of income to potentially save taxes of $68,250 ($480,000-$285,000) *35%. Income Tax Receivable $85,400 Income Tax Benefit Current $85,400 Step 3: Calculation of Deferred Tax Amounts: Deferred Taxes Temporary Differences (unchanged from Comprehensive Example 1): Step 1: Opening Deferred Tax Balance: Note that in this example, only the opening DTA amount of $4,800 is given. It may be helpful to unravel this amount by dividing it by its tax rate: $4,800/0.32=$15,000 Deductible Amount. From here, we can use this amount as a springboard to calculate our ending DTA/DTL amount. This dones as follows: Opening Difference: $15,000 Deductible

15 15 Deduct: Excess of CCA over depreciation ($20,000) Taxable Add: Excess of interest expense over interest paid $2,000 Deductible: Ending Difference: $3,000 Taxable Therefore, we would have an ending DTL amount of $3,050*0.35=$1,050. Step 2: To go from a $4,800 DTA opening balance (Step 2) to a $1,050 DTL (Step 1), the following entry would be made: Deferred Income Tax Expense $5,850. Deferred Tax Asset/Liability $5,850 Deferred Tax Loss Carryforward Asset: Note that the more likely than not criterion has been met, justifying the entry below: Deferred Income Tax Asset Loss Carryforward $68,250 Deferred Income Tax Benefit Tax Loss Carryforward $68,250 Income Statement effects of the above include the following: Income Tax Expense Benefit Current $85,400 DIT Expense (Timing Differences) ($5,850) DIT Benefit Tax Loss Carry forward $68,250 Total Income Tax Benefit: $147,800

16 16 Multiple Choice: The following information pertains to Questions 1, 2, and 3: During Year 18, Cray Inc. reported the following amounts: Meals and entertainment expenses $50,000 Gold Club Dues Paid for Executive $5,000 Depreciation Expense $20,000 CCA deducted for tax purposes $40,000 The tax rate for Year 18 was 25%. The tax rate for Years 19 and beyond is expected to be 28% but this rate has not been substantially enacted by the end of Year 18. At the start of Year 18, Cray Inc. had a Deferred Tax Asset of $31,000 on hand. Cray follows IFRS. 1. Assuming that Cray s Pre-tax accounting for Year 18 was $140,000, which of the following is correct? a) Taxable income for the year was $150,000, total income tax expense was $42,500, income taxes payable was $37,500 and there would be a Deferred Tax Asset of $26,000 at the end of Year 18. b) Taxable income for the year was $150,000, total income tax expense was $32,500, income taxes payable was $37,500 and there would be a Deferred Tax Asset of $36,000 at the end of Year 18. c) Taxable income for the year was $175,000, total income tax expense was $48,750, income taxes payable was $43,750 and there would be a Deferred Tax Asset of $26,000 at the end of Year 18. d) Taxable income for the year was $175,000, total income tax expense was $45,630, income taxes payable was $43,750 and there would be a Deferred Tax Asset of $29,120 at the end of Year Assume now that Cray reported pre-tax accounting loss of $60,000 for Year 18. In addition, Cray reported income for tax purposes from Years 15 through 17 amounting to $42,000 and

17 17 paid $11,000 in taxes during this period. Cray would like to carryback as much of its Year 18 loss and carry forward the remaining tax losses (assume the more likely than not criteria has been met). Based on this information, which of the following is correct? Assume that Cray uses a single deferred tax account to account for all temporary differences. Which of the following is correct? a) There was a loss for taxation purposes in the amount of $50,000. Cray is entitled to a tax refund of $10,500. Cray would have a Deferred Tax Asset (DTA) balance of $28,240. b) There was a loss for taxation purposes in the amount of $50,000. Cray is entitled to a tax refund of $11,000. Cray would have a Deferred Tax Asset (DTA) balance of $28,000. c) There was a loss for taxation purposes in the amount of $50,000. Cray is entitled to a tax refund of $10,500. Cray would have a Deferred Tax Asset (DTA) balance of $28,000. d) There was a loss for taxation purposes in the amount of $50,000. Cray is entitled to a tax refund of $11,000. Cray would have a Deferred Tax Asset (DTA) balance of $28, Assume now, that Cray Inc. follows ASPE and uses the Taxes Payable method. Cray s income tax expense for Year 18 would be: a) $42,500. b) $37,500. c) $45,630. d) $32, Bonham Inc., a publicly accountable company, began operations on January 1, Year 1. Selected accounting and tax information for the company are provided below Year 1 Year 2 Year 3 Income before income $250,000 $350,000 $450,000 taxes Depreciation expense $100,000 $100,000 $100,000 Capital cost allowance $170,000 NIL $180,000 (CCA) Income Tax Rate 20% 20% 25% The income tax rate was enacted during Year 3 and is expected to remain at 25% for the foreseeable future and all deferred taxes are expected to be realized in the future. On December 31, Year 3, what deferred taxes will be reported on Bonham s statement of financial position? Assume that there are no other temporary differences other than those shown above. a) Deferred tax asset of $10,000.

18 18 b) Deferred tax liability of $10,000. c) Deferred tax asset of $12,500. d) Deferred tax liability of $12,500 **N. B: As mentioned earlier, many candidates have difficulty understanding Deferred Taxes. Moreover, the Core 1 examination frequently isolates deferred income taxes for testing. The following questions should prove helpful in answering these questions. It is essential that candidates be able to hone in on these amounts very quickly.** 5. Kyle Inc. is a publicly traded company. The following information is provided with respect to Kyle s fixed assets at the end of Years 1 and 2. Book Value: End of Year 1: 200 End of Year 2: 120 UCC: End of Year 1: 180 End of Year 2: 150 The tax rates for Year 1 and prior was 20%. The tax rate for Years 2 and beyond was 25%. This rate was enacted during Year 2. Based on the above information, Kyle would report a Year 2 Deferred Income Tax (DIT) expense/benefit in the amount of a: a) $11,500 loss. b) $3,500 loss. c) $11,500 benefit. d) $3,500 benefit. 6. Joe Corp. has finance leases on its books with the following balances as the end of Years 1 and 2: Year 1: Assets under Finance Leases $180 Finance Lease Obligations $200

19 19 Year 2: Assets under Finance Leases $160 Finance Lease Obligations $125 The tax rates for Years 1 and 2 respectively were 40% and 35%. The Year 2 tax rate was enacted during Year 2. Based on the above information provided, Joe would have a Deferred Tax: a) Asset of $8,000 at the end of Year 1 and a Deferred Tax Liability of $12,250 at the end of Year 2. b) Liability of $8,000 at the end of Year 1 and a Deferred Asset of $12,250 at the end of Year 2. c) Asset of $8,000 at the end of Year 1 and a Deferred Tax Liability of $13,200 at the end of Year 2. d) Liability of $8,000 at the end of Year 1 and a Deferred Asset of $13,200 at the end of Year MNG Inc. bought a parcel of land for $500,000. Due to environment damage to the land, an appraiser estimated the value of the land to be $420,000, with no hope of a recovery to this value. MNG s tax rate has always been 30%. Assuming that there are no existing DTA/DTL balances, this impairment loss would result in a: a) Deferred Tax Asset of $24,000. b) Deferred Tax Asset of $12,000. c) Deferred Tax Liability of $24,000. d) Deferred Tax Liability of $12, Lennon Inc. has provided you with the following amounts: Excess of Rent Revenue Recognized over Rent Revenue Collected to Date: $1,000,000 Excess of Warranty Expenses accrued over Warranty Expenditures to Date: $ 400,000 Lennon is in the process of preparing its balance sheet for its most recent year and has asked you to compute its year-end Deferred Tax balance. Lennon is subject a tax rate of 20% for the current and future years.

20 20 For its most recent year, Lennon would report a Deferred Tax: a) Asset of $120,000. b) Liability of $120,000. c) Asset of $280,000. d) Liability of $280,000.

21 21 Answers: 1. Answer is A. We must first calculate taxable income as follows. Note that the current rate of 25% is used to account for the deferred taxes, since the new rate has not yet been enacted as at the end of Year 18. Note that this question is far more comprehensive and involved that what would be seen on the Core 1 examination, but it is excellent practice nonetheless: Pre-tax Accounting Income: $140,000 Add: Meals & Entertainment (50%) $25,000 Add: Golf Club Dues: $5,000 Timing Difference: Deduct: CCA in excess of Depreciation: (20,000) Taxable Income: $150,000 Income Tax Expense: Current (25%))* $37,500 Deferred (25%)** $ 5,000 Total Income Tax Expense $42,500 *This is also income taxes payable. **The shortcut approach can be used here by taking the difference between depreciation expense and CCA, since the tax rate is unchanged. The Deferred Tax Asset balance at the end of Year 18 would be computed as follows: Opening Balance $31,000 Less: Reduction due CCA in excess of depreciation: ($5,000) Ending balance: $26,000 Distractors: Choice b) This choice proceeds as per choice a), however it increases the DTA and reduces the DIT expense due to the timing difference:

22 22 Pre-tax Accounting Income: $140,000 Add: Meals & Entertainment (50%) $25,000 Add: Golf Club Dues: $5,000 Timing Difference: Deduct: CCA in excess of Depreciation: (20,000) Taxable Income: $150,000 Income Tax Expense: Current (25%))* $37,500 Less: Deferred (25%)** ($ 5,000) Total Income Tax Expense $32,500 *This is also income taxes payable. **The shortcut approach can be used here by taking the difference between depreciation expense and CCA, since the tax rate is unchanged. The Deferred Tax Asset balance at the end of Year 18 would be computed as follows: Opening Balance $31,000 Add: Reduction due CCA in excess of depreciation: $5,000 Ending balance: $36,000 Choice c) This choice incorrectly adds back 100% of the meals and entertainment expenses and proceeds accordingly: Pre-tax Accounting Income: $140,000 Add: Meals & Entertainment (100%) $50,000 Add: Golf Club Dues: $5,000 Timing Difference: Deduct: CCA in excess of Depreciation: (20,000) Taxable Income: $175,000 Income Tax Expense: Current (25%))* $43,750 Add: Deferred (25%)** $ 5,000 Total Income Tax Expense $48,750 *This would also be income taxes payable. **The shortcut approach can be used here by taking the difference between depreciation expense and CCA, since the tax rate is unchanged.

23 23 The Deferred Tax Asset balance at the end of Year 18 would be computed as follows: Opening Balance $31,000 Less: Reduction due CCA in excess of depreciation: ($5,000) Ending balance: $26,000 Choice d) This choice proceeds as per choice c) above. In addition, this choice incorrectly revalues the DTA using the rate of 28%, which has not yet been enacted: Pre-tax Accounting Income: $140,000 Add: Meals & Entertainment (100%) $50,000 Add: Golf Club Dues: $5,000 Timing Difference: Deduct: CCA in excess of Depreciation: (20,000) Taxable Income: $175,000 Income Tax Expense: Current (25%)* $43,750 Add: Deferred (25%)** $ 1,880 Total Income Tax Expense $45,630 *This would also be income taxes payable. **The shortcut approach can be used here by taking the difference between depreciation expense and CCA, since the tax rate is unchanged. The Deferred Tax Asset balance at the end of Year 18 would have been incorrectly computed as follows: Cumulative deductible difference at start of Year 18: $31,000/25% $124,000 Deduct CCA in excess of depreciation, Year 18: ($20,000) Cumulative deductible difference at end of Year 18: $104,000 DTA at the end of Year 18 (28%*$104,000) $29,120 DTA at the start of Year 18 (given) $31,000 DIT Expense, Year 18 ($31,000-$29,120) $1,880

24 24 2. Answer is B: Answer would be computed as follows: Pre-tax Accounting Loss: ($60,000) Add: Meals & Entertainment (50%) $25,000 Add: Golf Club Dues: $5,000 Timing Difference: Deduct: CCA in excess of Depreciation: (20,000) Taxable Loss: ($50,000) Carried back* $42,000 Carried Forward** $8,000 *Results in a refund of all prior taxes paid in the amount of $11,000. **Results in a Deferred Tax Asset (DTA) loss carry forward of $2,000 (i.e. $8,000*25%). The Deferred Tax Asset Balance at the end of Year 18 is computed as follows: DTA Temporary differences (from Question 1): $26,000 DTA Tax loss carry forward (from above): $2,000 Total DTA at the end of 2018: $28,000 Distractors: Choice a) Note that all choices provide the correct loss for tax purposes in the amount of $50,000. However, this choice is incorrect for two reasons. First, it incorrectly computes the tax refund as being the current tax rate of 25% 8 the prior tax losses of $42,000, giving an amount of $10,500 instead of the $11,000 in taxes actually paid. Next, this choice incorrectly values the tax loss carry forward of $8,000 ($50,000-$42,000 carried back) at the non-enacted rate of 28%, providing an incorrect DTA amount as follows: DTA Temporary differences (from Question 1): $26,000 DTA Tax loss carry forward* $2,240 Total DTA at the end of 2018: $28,240 *$8,000*28%=$2,240. Choice c) While this choice provides the correct loss for taxation purposes of $50,000, and the correct DTA amount of $28,000, it incorrectly computes the tax refund as being $10,500 as per choice a) above.

25 25 Choice d) While this choice provides the correct loss for taxation purposes of $50,000, and the correct tax refund of $11,0000, the DTA amount was incorrectly computed as being of $28,240 instead of $28,000 as per choice b). 3. Answer is B. Please refer to the answer to question 1. Under the taxes payable method, future taxes are simply not accounted for. The tax expense for the year is simply the amount of taxes owing, i.e. $150,000*25%=$37,500. Distractors: Choices a), c) and d) are all incorrect. 4. Answer is D: Total CCA taken to date (Years 1 to 3): $350,000 Total Depreciation taken to date: $300,000 Cumulative taxable difference $50,000 Tax rate: 25% Deferred Tax Liability (DTL) $12,500 Distractors: Choices a), b) and c) are all incorrect. 4. Answer is C: Cumulative Taxable difference at the end of Year 1: $20,000 ( ). This would give a DTL of $4,000 ($20,000*20%) Cumulative Deductible difference at the end of Year 2: $30,000 ( ). This would give a DTA of $7,500. ($30,000*25%) To go from a DTL of $4,000 to a DTA of $7,500, we need to record a DIT Benefit of $11,500. Distractors: Choices a), b) and d) are all incorrect. 5. Answer is B: Since assets are lower than liabilities at the end of Year 1, we would have a DTL of (200, ,000) *40% =$8,000. Since liabilities are lower than assets at the end of Year 1, we would have a DTA of (125, ,000) *35% =$12,250. Distractors: Choices a, c) and d) are all incorrect. 6. Answer is B:

26 26 This would result in a DTL because tax write-down (which is a benefit) will occur later on when the land is written down or sold. Thus, the answer would be a DTA of ($500,000- $420,000) *30%*1/2=$12,000. Do not forget to multiply by 50% here. Distractors: Choices a, c) and d) are all incorrect. 7. Answer is B: Rent (Taxable difference) = $1,000,000*20%= Warranties (Deductible difference) -=$400,000*20%= Net: Distractors: Choices a, c) and d) are all incorrect. $200,000 DTL $80,000 DTA $120,000 DTL